Why Paulson's Plan Works

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Now that I've had two weeks to think about it, I like Treasury Secretary Henry Paulson's blueprint for overhauling the regulation of our financial institutions. I don't think it's perfect, but many of its aspects get a thumbs-up from me.

Most critics' first complaint is that the plan is a knee-jerk reaction to the credit-market mess. In reality, Paulson and company have been formulating the plan since March 2007. Keep in mind that the plan outlines an ideal structure that would need to be implemented over many years, with many intermediate steps along the way.

It's probably a fair point that this blueprint might not have been formulated without the current credit crisis. Then again, we wouldn't have the FDIC insuring our deposits, or the SEC requiring financial disclosures, without the Great Depression.

How bad is it?
If you're questioning whether we really need better regulations, you may not have gotten your Banks Gone Wild DVDs in the mail the last few months.

The banks that originated many of the now-toxic home loans are teetering. Washington Mutual (NYSE: WM) announced a highly dilutive $7 billion capital infusion last week, and I'm not sure that influx will ultimately be enough to keep the company afloat. Meanwhile, Countrywide (NYSE: CFC) is in the process of being rescued by Bank of America (NYSE: BAC) for a fraction of its stated book value. Most other notable banks are writing down loans almost as fast as they were handing them out during the boom.

The investment banks that financed much of the mess are even scarier, because of their heavy use of leverage and exotic financial instruments. We all know about Bear Stearns' (NYSE: BSC) fall from grace, and Lehman Brothers' (NYSE: LEH) liquidity concerns have been news ever since.

The banks and their shareholders are paying for their mistakes, which is fine. That's how capitalism works. However, a bank failure has wider consequences for the economy than, say, a retailer going under. That's why you frequently hear the phrase "too big to fail" in regard to these companies. It's less of an economic pain for the government to bail out a bank than let it fail and deal with the consequences.

Because of greed -- and a lack of regulation to stem that greed -- the Fed had to step in to keep Bear Stearns from sinking. Offering guarantees for $29 billion of the Bear Stearns debt that JPMorgan Chase (NYSE: JPM) took on as part of its purchase agreement was the best the Fed could do, given the circumstances. Paulson's plan is an attempt to reduce the chances that the government will end up in that situation again.

What's the plan?
Though critics charge that he wants more regulation, Paulson's just calling for smarter regulation. Financial markets evolve much faster than regulators can. Was anyone even talking about Structured Investment Vehicles a year ago? This speedy, consistent change has made our financial regulatory system a confusing morass of various overlapping state and federal regulators, each developed to deal with previous innovations.

Here's Paulson's proposed fix for this mess:

• Consolidating financial regulation into three federal entities: 1. A market stability regulator that would regulate capital, liquidity, and margin practices across the entire financial system. 2. A prudential financial regulator that would ensure the safety and soundness of all institutions with federal guarantees. 3. A conduct business regulator that would protect consumers and regulators.
  
• Favoring federal regulation vs. state regulation.
  
• Grouping regulation responsibilities by objective, not by the type of organization being regulated. (Who cares about the differences between a thrift and a traditional bank if they're both issuing mortgages?)
  
• More regulation for investment vehicles deep within the financial system, such as hedge funds and derivatives.

Will it work?
In short, the plan would provide a clear set of three federal regulatory bodies with authority over our entire financial system, from commercial banks to hedge funds to investment banks to public companies to insurers. This makes perfect sense to me. I prefer federal regulation to state regulation (if I move from one state to another, I want my new bank to follow the same rules as my old bank), and I think it's about time that highly leveraged, mysterious hedge funds were regulated. Except for some visibility into the public hedge funds like Blackstone (NYSE: BX), these investment vehicles have been a complete black box.

Though I like Paulson's proposed structure, I do fear that this regulatory system would encourage attempts to micromanage the economy. Paulson would like the Federal Reserve to be the "market stability regulator." As Chuck Saletta pointed out in an article last week, Paulson envisions a far more powerful Fed than the current version. If the Fed takes as fine-toothed an approach to the entire financial system as it currently does with its interest rate policy, I fear we're in big trouble.

Let's hope that the government improves our financial regulation without trying to play market master.

Further fiscal Foolishness:

• Buffett Beats Bernanke
• Free Markets? What a Joke.
• Uncle Sam Should Bail Out Banks